Investors who want a slightly higher return, and are willing to accept more risk, will buy mortgages. Instead of buying the mortgages directly, they usually purchase products backed by mortgages, called (you guessed it) mortgage-backed securities. When Treasury yields rise, mortgages also have to provide higher returns to attract investors. The result to the borrower? Higher interest rates.
Those who are willing to do a little research into specific companies will purchase corporate bonds, which are rated as to their level of risk. Bond yields are also somewhat affected by Treasury yields, as well.
How Do Treasury Notes Work?Treasury notes and bonds are sold by the U.S. Treasury Department to pay for the U.S. debt. Treasury notes are issued in terms of 2, 3, 5, and 10 years, while Treasury bonds are issued in terms of 30 years. Treasury bills are issued in terms of one year or less. However, many people just refer to all of them as Treasury bonds, Treasury products or even just Treasuries. The most popular Treasury product is the 10-year note.
Treasury notes and bonds are sold at auction by the Treasury Department, which sets a fixed face value and interest rate. If there is a lot of demand for the note or bond, it will go to the highest bidder at a price above the face value. This decreases the yield, which is a common term used to describe the total amount of money you make on a U.S. Treasury note or bond. It lessens the yield because, regardless of how much you bid for the note, the government will only pay back the face value plus the stated interest rate. If, on the other hand, there is not a lot of demand, then the bidders will pay less than the face value, which increases the yield. That is why yields always move in the opposite direction of Treasury note prices.
Treasury note and bond yields change every day, because hardly anyone keeps them for the full term. Instead, they are resold on the open market. Therefore, if you hear that bond prices dropped, then you know there is not a lot of demand for Treasury notes and bonds, and that the yields increased. This makes it more expensive to buy a home, because mortgage interest rates rise. That lessens demand for homes, which puts downward pressure on home prices. This slows economic growth.
Conversely, low yields on U.S. Treasury notes mean lower rates on mortgages. This allows homeowners to afford a larger home, and renters to afford their first home. This increased demand stimulates the real estate market, which stimulates the economy. Lower mortgage rates also allow homeowners to afford a second mortgage, which allows them to purchase more consumer products. This also stimulates the economy.
Treasury Yields Only Affect Fixed-Rate MortgagesIt is important to know that Treasury yields only affect fixed-rated mortgages. The 10-year note affects 15-year conventional loans, while the 30-year bond affects 30-year conventional loans.
Adjustable rate mortgages are affected more by the Fed funds rate. This is set by the Federal Reserve. It is the rate banks charge each other for overnight loans needed to maintain their reserve requirement with the Fed. The Fed funds rate affects LIBOR, which is the rate banks charge each other for one, three and six month loans. It also affects the prime rate, which is the rate banks charge their best customers. Since the Fed funds rate affects LIBOR and other short-term interest rates, it also affects adjustable-rate mortgages, since these typically adjust on a semi-annual or annual basis.
Recent Rate Trends and OutlookBetween May and September 2013, the 10-year Treasury yield rose more than 75%, to 2.98%. The yield started rising after Federal Reserve Chairman Ben Bernanke announced the Fed may start tapering off its purchases of Treasuries and other securities. The Fed has been buying $85 billion a month since September 2011. See more about Quantitative Easing.
Rates continue to rise as the economy improves and investors switch to stocks and real estate investments. Citi forecasts that the 10-year Treasury yield will break 3% next year, while Wells Capital Management says it will happen this year. (Source: CNBC, Market Consensus: Get Ready for 3% Treasury Yields, June 19, 2013)
Why Rates Fell to a 200-Year LowOn June 1, 2012, the yield on the 10-year Treasury note dropped briefly during intra-day trading to 1.442%, the lowest in 200 years. By the end of the day, the rate closed just a bit higher, at 1.47%. Nevertheless, this forced mortgage interest rates down to record lows.
Why was the Treasury yield so low? Investors were panicked by a lower-than-expected jobs report, and by ongoing worries about the eurozone debt crisis. They sold stocks, driving the Dow down 275 points. They put their cash into the only safe haven, U.S. Treasury notes. (Gold, the safe haven in 2011, was down thanks to lower economic growth in China and the other emerging market countries.)
Investors still hadn't recovered their confidence from the stock market crash of 2008. In addition, they were uneasy that the Federal government would allow the economy to fall off the fiscal cliff. Add in the uncertainty around a Presidential election year, and you had a situation that might not occur for another 200 years. Article updated September 5, 2013